Saturday, February 06, 2010

The current crisis is rooted in the poor performance of mortgage loans made between 2005 and 2007. If the CRA did indeed spur the recent expansion of the subprime mortgage market and subsequent turmoil, it would be reasonable to assume that some change in the enforcement regime in 2004 or 2005 triggered a relaxation of underwriting standards by CRA-covered lenders for loans originated in the past few years. However, the CRA rules and enforcement process have not changed substantively since 1995.

Three things. The first is that the same Minneapolis Fed that published the above contradicts the claim that nothing important has changed substantively since 1995.

In early 2005, largely at the behest of the banking sector, the Office of Thrift Supervision implemented new rules that were widely perceived as weakening the CRA. Supervision of banks with under $1 billion in assets was loosened, and larger banks were allowed to voluntarily reduce the amount of regulator scrutiny of their "investment" and "service"-two long-standing categories of assessment under the CRA.

This had two unintended consequences that would later prove to be very costly. In the first place, it increased CRA scrutiny of larger banks, who were now the main focus of regulators. This put even more pressure on the banks to make CRA loans. Secondly, by allowing banks to de-emphasize "investment" and "service," the new regulations created an even greater incentive for banks to meet CRA obligations by making home loans.

Emphasis above mine. Differences in CRA performance between large and small banks is discussed below.

The SEC rule change in 2004 that changed how the SEC figured the net capital requirements is now seen as a significant mistake. Some journalists have mistakenly called this deregulation. What these journalists fail to note is that this rule change was the antithesis of deregulation; rather it was the imposition of internationally coordinated regulatory standards—rules known as the “Basel Rules.” The Basel Committee rules were the consequence of years of work by the central bankers of the world and are based on the belief that a common set of global banking standards would result in more efficient use of capital and a more stable global financial system. The Basel rules call for banks to have capital reserves of eight percent on a risk weighted basis. Commercial loans had a risk weight of 100, so had to be backed by 8 percent capital in reserve. But AAA rated securities (like the securitized mortgage pools), had a substantially lower risk weight of 20 percent, so banks only had to have 1.6 percent capital in reserve to back investments in AAA rated securities....The SEC rule change was one of the regulatory failures that contributed to the financial crisis. But rather than a deregulation problem, this is a cautionary tale against agreement to internationally coordinated regulatory standards. If they substitute for prudential regulation, they could be a lot worse.

Another SEC rule change in 2004 replaced explict rules with SEC micromanaging. While the stated goal was to check the activity of investment banks in detail, the end result (given that the government did not know any more about what was going on than the bankers did) was that the government simply used the banker's models. Investments in mortgage backed securities were one of the reasons for the change:

But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.

On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

Arnold Kling (who was an economist on the staff of the Federal Reserve Board in the 1980s and an economist with Freddie Mac) explains further:

To foster homeownership, policymakers promoted mortgage lending that was subsidized and lenient. Requirements for down payments were relaxed, as were requirements for borrowers to prove they had the ability to repay their loans....

Washington also was responsible for creating and supporting the process of mortgage securitization. At the time, this was viewed as a way to lower the cost of mortgage credit and stabilize the mortgage lending industry.

Finally, it was bank capital requirements designed by regulators that induced bankers to weave the crazy quilt of collateralized debt obligations, credit default swaps on mortgage securities and off-balance-sheet financing....

The problem here is that large institutions tended to perform much more poorly under the CRA than smaller ones (and large programs performed worse than small ones). This is made even more serious by how much a factor the large banks were; 94% of the $6 trillion in CRA commitments made between 1992 and 2008 "were made by banks and thrifts that were or ended up being owned by just four banks: Wells Fargo, JP Morgan Chase, Citibank, and Bank of America". These four banks, in addition to Fannie Mae and Freddie Mac, are responsible for "an estimated 70% or more of outstanding CRA loans". More on Bank of America's CRA performance below. Remember this the next time someone tries to defend government "affordable housing" initiatives by pointing to small programs from small lenders with good statistics, usually studied during the housing boom when rising prices prevented foreclosures (people sold homes they couldn't afford for a profit instead of letting the banks take them back). No statistic from any small program or small lender from before the crash proves these programs innocent of anything.

In total, of all the higher-priced loans, only 6 percent were extended by CRA-regulated lenders (and their affiliates) to either lower-income borrowers or neighborhoods in the lenders' CRA assessment areas, which are the local geographies that are the primary focus for CRA evaluation purposes. The small share of subprime lending in 2005 and 2006 that can be linked to the CRA suggests it is very unlikely the CRA could have played a substantial role in the subprime crisis.

...it doesn't include subprime loans — or securities — bought by CRA-covered banks. Mortgages originated by independent mortgage companies can be bought by banks to get CRA credit. Nor does the study include the billions in public commitments big banks made to lend to low-income and minority households to buy off Acorn and other CRA lobbyists.

Large banks weren't the only institutions buying CRA loans (and securities based on those loans). Approximately 50% of CRA originations since the mid-1990s were acquired by Fannie Mae and Freddie (the GSEs) to help them meet HUD-mandated affordable housing (AH) goals. At the same time as CRA enforcement was hitting large institutions hard, Fannie and Freddie were ramping up:

It appears that this aggressive expansion of Fannie Mae and Freddie Mac into subprime lending was a political strategy adopted by their leaders in response to heightened congressional scrutiny and criticism in the wake of the accounting scandals at the agencies that emerged during 2003 to 2004 and which threatened to lead to a revocation of their favored status as government-sponsored enterprises. Fannie and Freddie aggressively restyled their lending operations as the promotion of affordable housing and actively encouraged retail lenders to generate mortgages with those characteristics. As a result, not only did the number of subprime loans explode in the 2005 to 2007 period, but a disproportionate number of these loans were made to the riskiest borrowers or had extremely high risk characteristics, such as negative amortization, interest-only, high-LTV, or very low FICO scores.

...The 1992 affordable housing goals required that, of all mortgages Fannie and Freddie bought in any year, at least 30 percent had to be loans made to borrowers who were at or below the median income in the places where they lived. Over succeeding years, the Department of Housing and Urban Development (HUD) increased this requirement, first to 42 percent in 1995, to 50 percent in 2000, and finally to 55 percent in 2007. It is important to note, accordingly, that this occurred during both Democratic and Republican administrations....

...[According to] Fannie's 2006 10-K report makes clear, is untrue:

[W]e have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet HUD's increased housing goals and new subgoals. These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions. We have also relaxed some of our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products that are more likely to serve the borrowers targeted by HUD's goals and subgoals, which could increase our credit losses.

...

You can see this GSE activity in this chart from Mark A. Calabria of Cato.org. According to Calabria, "during the bubble years, Fannie and Freddie were the largest single source of liquidity for the subprime market. And the chart doesn’t even take into account all the subprime whole loans being purchased by the GSEs." The vertical axis values are USD billions (bars) and market share (line).

...the epicenters of the mortgage crisis are inner-city urban areas--precisely those areas where the CRA was most applicable. As the Boston Federal Reserve put it in a massive 2008 study, "In the current housing crisis foreclosures are highly concentrated in [urban] minority neighborhoods." The study found that borrowers in these areas were seven times more likely to be foreclosed on than the general population. Analysis by the Pew Research Center and another by The New York Times found that mortgage holders in these areas had foreclosure rates four times higher than the national average.

One additional question. If Fannie and Freddie were lying about their profits from this activity, and that 'profitability' encouraged private entities to get into the business, are Fannie and Freddie absolved of any guilt concerning the results? Also, as the chart from Cato shows, the GSEs made MBS purchases from private entities. Private entities issuing an increasing amount of those securities doesn't get either GSE off the hook for them or their consequences, particularly when agents of Fannie claimed credit for that market when doing so suited their purposes.

The data shows that the principal buyers [of almost 25 million subprime and other nonprime mortgages—almost half of all U.S. mortgages] were insured banks, government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, and the FHA—all government agencies or private companies forced to comply with government mandates about mortgage lending. When Fannie and Freddie were finally taken over by the government in 2008, more than 10 million subprime and other weak loans were either on their books or were in mortgage-backed securities they had guaranteed. An additional 4.5 million were guaranteed by the FHA and sold through Ginnie Mae before 2008, and a further 2.5 million loans were made under the rubric of the Community Reinvestment Act (CRA), which required insured banks to provide mortgage credit to home buyers who were at or below 80% of median income. Thus, almost two-thirds of all the bad mortgages in our financial system, many of which are now defaulting at unprecedented rates, were bought by government agencies or required by government regulations.

According to Michael Cembalest, the Chief Investment Officer of JP Morgan Private Bank, "What emerges from new research is something quite different: government agencies now look to have guaranteed, originated or underwritten 60% of all “non-traditional” mortgages, which totaled $4.6 trillion in June 2008. What’s more, this research asserts that housing policies instituted in the early 1990s were explicitly designed to require US Agencies to make much riskier loans, with the ultimate goal of pushing private sector banks to adopt the same standards."